On Wednesday, the Bureau of Economic Analysis (BEA) reported that the world’s biggest economy grew at a measly 1.8 percent, far-below analysts most pessimistic predictions. The news that the US economy had “slowed to a crawl” was immediately felt on Wall Street where jubilant traders loaded up on equities sending all three indices up sharply led by the Dow Jones which logged 149 points on the session.

Huh? So why did the bad news on growth send stocks higher?

Let’s call it the QE conundrum, although it’s really not a mystery, not to the folks who watch the markets at least. You see, bad is good and good is bad. When the economic data comes in below expectations, stocks rise because traders know the Fed’s trillion dollar stimulus program will continue ad infinitum. And when the data comes in above expectations, then–watch out– because markets will tumble as traders worry that the $85 billion per month liquidity injections will be curtailed or terminated altogether. So bad is good and good is bad. Simple, eh?

This is how Bernanke has turned the equities markets on their head. In this Bizarro world of zero rates and easy money, fundamentals and earnings don’t matter any more, what matters is regular injections of liquidity-meth provided gratis by our friends at the Central Bank. That’s what pushes stock prices higher.

Last week, Bernanke surprised the markets by announcing that he wants to end QE sometime in 2014 to avoid emerging asset bubbles and to return the financial markets to normal. Here’s what he said on May 22 following the meeting of the FOMC:

“We’re trying to make an assessment of whether or not we have seen real and sustainable progress in the labor market outlook. If we see continued improvement and we have confidence that that is going to be sustained, then we could in — in the next few meetings — we could take a step down in our pace of purchases.”

Freakout! That’s all it took to send stocks off a cliff. And while the ructions in the equities markets were impressive, to say the least, the carnage in the bond market was flat-out shocking. As journalist Mark Gongloff pointed out, “The bond market.. suffered its worst selloff in 50 years….Heckuva job, Bernanke!” (Mark Gongloff) Here’s a short blurb from Gongloff’s piece at Huffington Post:

“Since early May, the yield on the benchmark 10-year Treasury note has jumped one full percentage point, from 1.62 percent to 2.62 percent on Monday morning. This represents a 62 percent increase in borrowing costs for the Federal government — and also for mortgage borrowers, because mortgage rates are directly tied to the 10-year note rate — in just a month.

It is the biggest single move in interest rates since at least 1962, according to Dan Greenhaus, chief global strategist at the New York brokerage firm BTIG.

Thanks to this rise in the 10-year note yield, the average going rate for a 30-year fixed-rate mortgage has also risen by a full percentage point, to about 4.4 percent, according to Walter Schmidt, a mortgage strategist at FTN Financial in Chicago.

The surge in rates will likely squeeze mortgage refinancing and borrowing and could smother the recent rebound in the housing market, which has largely been driven by investors taking out cheap loans to buy cheap houses. Regular borrowers were already having a hard time finding loans, and they’ll have an even harder time now.”

And it’s not just the housing market that’s going to be blind-sided by Bernanke’s sudden volte-face, bank balance sheets are also on the chopping block as this article in the Financial Times points out:

“The recovery in global banks’ balance sheets is under threat from a surge in bond yields, according to senior bank executives and analysts preparing for quarterly earnings season.

Banks have built giant portfolios of liquid securities, partly at the behest of regulators and also because they have not found better opportunities to lend a flood of deposits….

The composition of the balance sheets leaves banks vulnerable to the spike in interest rates. For example, Bank of America has a $315 billion securities portfolio, 90 percent of which is invested in mortgage-backed securities and Treasurys. As yields rise, prices fall….

“I would think most institutions are going to have a fairly sizeable hit to their equity,” said a senior executive of a top U.S. bank. “You’ve really had this concentrated one-to-two week period where all hell is breaking loose.”

Indeed, there could be some “nasty losses” for Bernanke’s favorite constituents, the banks, which is why he must have breathed a sigh of relief when Q1 GDP came in below expectations on Wednesday because–as we said earlier–the crappier the data, the better the chance Maestro Ben will keep the QE-flywheel cranking out more greenbacks. Here’s a little more background on the bond market mayhem from the Gray Lady:

“Wall Street never thought it would be this bad.

Over the last two months, and particularly over the last two weeks, investors have been exiting their bond investments with unexpected ferocity, moves that continued through Monday.

A bond sell-off has been anticipated for years, given the long run of popularity that corporate and government bonds have enjoyed. But most strategists expected that investors would slowly transfer out of bonds, allowing interest rates to slowly drift up….

The recent pain has spilled over into stock markets, pushing the Standard & Poor’s 500-stock index down an additional 1.2 percent on Monday. But the real pressure has been felt in the bigger and more closely watched bond market….

“The feeling you are getting out there is that people are selling first and asking questions later,” said Hans Humes, chief executive of the hedge fund Greylock Capital.”

Sounds serious, doesn’t it? Sounds like the world’s biggest and most liquid market (USTs) could be facing some ferocious headwinds in the near future thanks to Uncle Ben’s grandiose “pump-priming” experiment.

So how is Bernanke going end QE? What’s the so called “exit strategy”?

No one really knows for sure, because nothing like this has ever been attempted before. We’re in uncharted water. But, one thing is certain, the days of smooth sailing where stocks march in lockstep with the Fed’s monthly injections are probably over. Investors no longer believe in the “Bernanke Put”, that is, that the Fed will intervene to support stock prices. They know now that the Fed wants to scale back on its asset purchases and to wind down the program. That’s going make traders antsy, which will lead to more volatility, more selloffs, more capitulation.

So, there’s no free lunch after all. Bernanke thought he could keep stocks levitating while the real economy languished in a long-term slump, but he was wrong. Volatility is baaack with a vengeance, and serious stock and bond wackage lies dead-ahead.